Financial Force Direction

Force vectors are made up of two components:

1. Magnitude
2. Direction

In the previous article, we looked at an approach for determining the magnitude of the two primary financial forces, economic growth and inflation.?

Today, we are going to talk about the direction of these forces.

The title image shows the direction the forces tend to act when economic growth exceeds expectations and when inflation exceeds expectations. If growth or inflation fall short of expectations, the vectors would point in the opposite direction.?

Before reading further, look at the title image for a few minutes and think through what higher than expected economic growth and inflation would likely do to the price of each asset. Do you agree with the directions shown?

Now that you have drawn some of your own conclusions, keep reading for further explanation of the direction of the forces on each asset.

Stocks are priced based on the profitability of companies. If economic growth is higher than expected, revenues and profits go up and stock price generally follows. If inflation is higher than expected, company expenses increase and profit and stock prices tend to go down.?

Bond prices move inversely to interest rates. If economic growth is higher than expected or inflation is higher than expected, both tend to have a negative effect on the price of bonds. This is because the government will raise interest rates in order to make it less attractive to borrow money. Their aim in doing this is to limit economic activity and bring inflation rates back to reasonable levels. The newer, higher interest rates on bonds will make bonds with lower interest rates less attractive on the open market and therefore cause a fall in the price of those bonds.?

Commodities tend to do well when economic growth is higher than expected and inflation is higher than expected. This is pretty self-explanatory. Economic growth drives demand and demand drives prices of commodities higher.?

Treasury Inflation Protected Securities (TIPS) and gold are a bit harder to comprehend. The first thing to understand is that TIPS are a treasury bond with an inflation adjustment. Economic growth tends to be a headwind for both TIPS and gold due to similar reasons as bonds mentioned above. However, given the tie to inflation, TIPS tend to do well when inflation exceeds expectations. Same can be said about gold over longer periods of time. It is a commodity with limited supply after all.?

To sum up the series so far, here is a reminder of what we have covered over the first few articles:

1) Assets will maintain their positive expected return unless acted on by a force.

2) The two major forces include economic growth and inflation.

3) The equation for force magnitude:

F = M*A? →? F = M*(V2 - V1) / T

Where:

F = Force

M = Mass of Market

A = Acceleration

V1 = Initial Economic Growth or Inflation

V2 = Final Economic Growth or Inflation?

T = Time

4) The forces have a tendency to act in certain directions on assets:

Stocks - Do best when economic growth exceeds expectations and inflation falls short of expectations

Bonds - Do best when economic growth and inflation fall short of expectations

Commodities - Do best when economic growth and inflation exceed expectations

TIPS/Gold - Do best when economic growth falls short of expectations and inflation exceeds expectations

Now that we have all of this in place, we can begin to build a portfolio that attempts to maintain the initial expected return while balancing out the forces as much as possible.